Islamic Banking and Finance Vehicle Financing 06 PDF

ECON 3430 - Islamic Banking and Finance Vehicle Financing  Outline Ijarah Contract and Its Salient Features Al-Ijarah Thumma al-Bay (AITAB) Financial lease Islamic perspective on financial lease Some applications of ijarah-based...

ECON 3430 - Islamic Banking and Finance Vehicle Financing  Outline Ijarah Contract and Its Salient Features Al-Ijarah Thumma al-Bay (AITAB) Financial lease Islamic perspective on financial lease Some applications of ijarah-based financing Direct leasing Sale and leaseback Decreasing sale and joint lease  TOPIC 1 Ijarah Contract Loading…  Basics of Ijarah Contract: Sale of usufruct (legal right to use another person’s property) (bay’ al manfa’ah) Usufruct : The right to use and enjoy the profits and advantages of property belonging to another as long as it is not damaged or altered in any way Two types of usufruct Usufruct of property or capital assets (manfa’ah al-’ayn) Usufruct of labour, employment and service (manfa’ah al-’amal) In ijarah-based financing, ijarah ‘ayn is applied Lessor (mu’jir) leases property to the lessee (musta’jir) in exchange for lease or rental payment (‘ujrah) Ijarah contract is different from bay’ (sale) contract such that with ijarah, ownership of property is not transferred Comparable (but not identical) to conventional leasing contract  Salient Features of the Ijarah Contract Asset to be leased must have a valuable use Asset to be leased must not be consumable: must be returned to the lessor in its original form at the end of the lease period However, normal wear and tear excepted Ownership of asset remains with lessor and only the usufruct is transferred to lessee Loading… Liabilities and risks incidental to ownership will reside with the lessor However, risks and expenses associated with the usage of the leased asset reside to lessee Lease contract is a bilateral contract Under normal circumstances, termination must be mutually agreed Upon loss or non-existence of usufruct, the ijarah contract is terminated  Terms and Conditions of Ijarah Contract Period of the ijarah arrangement must be clearly specified Purpose and mode of usage should be agreed upfront The leased asset is a trust in the hands of the lessee Lessee liable for damage only due to negligence Lessee does not guarantee the safeguarding of the leased asset nor indemnifies the lessor of damages Rental payment must commence after the delivery of the leased asset either actually or constructively (e.g. give keys to house) Issue - What if there is a gap between time of disbursement by lessor and delivery of leased asset to lessee by vendor? Some jurists opine that lessor can demand a security which will constitute advanced rental  TOPIC 2 Ijarah-based Vehicle Financing  Ijarah-based Vehicle Financing The original contract of ijarah do not result in ownership of the property by the lessee (person seeking financing) However, consumers seek vehicle financing for the purpose of eventually owning the vehicle As such, a special type of ijarah contract is required to enable eventual ownership of the leased property by the lessee In Malaysia, this type of ijarah contract is known as Al-Ijarah Thumma Al-Bay’ (AITAB) or “leasing ending with sale” (ijarah muntahiya bi tamlik)  Al-Ijarah Thumma Al-Bay’ (AITAB) AITAB comprises two different contracts Contract of leasing (ijarah) Contract of sale (bay’) A creation of modern day fuqaha Contract of AITAB not readily found in classical books of fiqh In Malaysia, despite having Shari’ah origins, AITAB is governed by (conventional) civil law, namely the Hire-Purchase (HP) Act 1967 Hence, to understand the operation of AITAB one needs to understand the HP Act 1967  Hire-Purchase Act 1967 Under the HP Act 1967, the modus operandi of vehicle hire-purchase is as follows: Bank purchases vehicle from vehicle dealer Bank as owner of vehicle leases the vehicle to the customer according to agreed terms and conditions (including rental and lease period) The customer can return the vehicle at any time prior to exercising option to buy and thus terminating the agreement, customer is not obligated to pay all the rentals (if want to change, upgrade car) The customer has the option to purchase the vehicle at a nominal value after all rental payments have been made AITAB Modus Operandi vehicle 3. Bank Car Dealer Vehicle purchases purchase identified price vehicle 1. Customer identifies 2. Customer vehicle of choice engages Bank Loading… for financing 4. Ijarah contract Use of vehicle Rental payments Bank Customer 4. Promise to sell 5. At end of ijarah period, Bank sells vehicle to Customer for nominal price  AITAB Fiqh Issues AITAB cannot be constructed to imply that it is a combination of two different contracts That is, it is not a leasing (ijarah) contract with a condition to sell (bay’) Rather, it is a contract of leasing (ijarah) with a promise (wa’ad) to sell Two different contracts are executed at two different stages Execute contract of leasing (ijarah) with a promise to sell Once the lease expires and lessee has made all payments, the lessor is obligated to fulfill his promise to sell by executing the contract of sale (bay’)  AITAB Fiqh Issues (2) The conventional hire-purchase is, in essence, an interest-bearing term loan Given that AITAB falls under the purview of the HP Act 1967, its characteristics seem to emulate that of the conventional hire-purchase Critical issues Despite the fact that the bank is the lessor and owner of the vehicle, all risks and liabilities of ownership are effectively transferred to the lessee Insurance, road tax, major maintenance Absence of element of ‘iwad in the bank’s profit in the leasing arrangement The bank does not undertake any market risk as it does not function as a true lessor of vehicles, merely providing the financing Similarly there is no value-added effort on the part of the bank as it is the customer who identifies the vehicle and merely sources financing from the bank In the event of product defect, recourse is with the car dealer or manufacturer, not the bank  AITAB Fiqh Issues (3) In the event of late payment, can the bank levy late payment charges? Rental when due is debt payable by lessee Subject to all rules prescribed for a debt, cannot charge extra=riba But to provide a deterrent, can be included in contract at the very beginning, shariah scholars allow penalty payable to charity, cannot become part of income of lessor Known as compensation charges Can rental payment be on floating rate basis? Yes, should be stated in the contract, particularly for long duration leases Can be different rates for different phases based on any agreed benchmark during the lease period Can be mutually agreed to review the lease period and/or rental (refinance)  AITAB Fiqh Issues (3) Can leased assets be securitized? Yes, provided ownership of goods being transferred to the third party Good potential for securitization & creation of a secondary market for investors Basis for “sukuk ijarah’ or leasing certificates What if the lessee wishes to terminate the lease agreement early? Ijarah a binding contract, once executed, cannot be revoked unilaterally Can be amended with mutual consent Does lessor have right to repossession in the event of default payment? Yes, should be stated in the contract  TOPIC 3 Financial Lease  Financial Lease (2) Businesses often require financing to purchase high cost items: machinery, equipment, other fixed assets and even land and buildings – resort to leasing In conventional leasing, two types of leases: Operating lease: Lessor owns asset Bears maintenance costs and ownership risks Lessor takes back the asset at the end of leasing period Considered compatible with shari’ah Suitable for high cost asset – aircraft Rarely used by banks Financial lease : Lessor only “technically” owns asset Maintenance costs and ownership risks are borne by the lessee Commonly adopted by banks – hire purchase Rental included cost of purchasing asset plus interest during the lease period  Financial Lease (2) Key features of a financial lease Lease period equals expected useful life of asset Acquisition of asset is part of leasing arrangement Bank would not purchase asset without first securing lease contract with lessee Total lease payments equal cost of asset plus bank’s profit margin Reflecting opportunity cost of funds (typically the market interest rate) All risks and liabilities associated with asset ownership are transferred to the lessee  Financial Lease (3) Effectively, financial lease is simply an interest-bearing loan So why would businesses lease instead of borrowing? Purely tax and/or accounting motive: in certain circumstances it is advantageous to lease instead of borrow Business paying less tax – asset being leased not owned To window dress accounting figures and ratios - business is less leveraged  TOPIC 4 Islamic Perspective on Financial Lease  Financial Lease Effort to apply ijarah as a mode of financing extends beyond vehicle financing Islamic financial institutions have resorted to a type of ijarah contract which is loosely comparable to the conventional financial lease Basic idea: Bank finance purchase of an asset via a leasing arrangement At end of lease period, ownership of asset is transferred to customer Terms: al-ijarah wa al-iqtina, al-ijarah al-muntahia bitamlik and al-ijarah thumma al-bay’ have been used interchangeably  The Islamic Perspective on Financial Lease A key characteristic of leases is predetermined and fixed income or return (in the form of lease rental payments) How is this different from an interest-bearing loan? Riba-based loans: money is treated as the commodity Leasing/ijarah: usufruct of a tangible property is the commodity or object of sale Although rental payments are fixed, return to lessor is not. Lessor has to bear two types of risk Market risk: In a true leasing business, lessor acquires the lease asset prior to securing any leasing contracts. Thus, asset is subject to price risk: risk that lessor is not able to profitably lease out asset Operational risk: Maintenance costs can sometimes exceed rental income thereby resulting in a loss to lessor  The Islamic Perspective on Financial Lease (2) It is for this reason (undertaking of risk which constitutes ‘iwad) that Islam has permitted ijarah and prohibited riba Hence, from a Shari’ah perspective, one critical factor in determining the permissibility of any ijarah arrangement is whether the lessor actually bears risks expected of a true lessor (ownership risks and maintenance costs) Thus, shari’ah only recognizes operational leases and not financial leases (as implemented in the conventional manner) as valid forms of the ijarah contract Financial leases, as practised conventionally, are in substance nothing other than interest-based loans Any attempt to structure ijarah arrangements to this effect is merely means of circumventing the prohibition of riba on technical grounds  TOPIC 5 Some applications of ijarah- based financing Direct leasing Sale and leaseback Decreasing sale and joint lease  Some Applications of Ijarah-based Financing These essentially are leasing contracts that end with lessee owning asset Some examples Direct leasing (al-ijar al-mubashir) Sale and leaseback (al-bay’ wa i’adah al-isti’jar) Decreasing sale and joint lease (al-bay’ al-tadriji wa ikhtisas al-sharik bi al-ijarah) Forward lease  Direct Leasing 3. Bank pays airplane manufacturer Airplane Bank Manufacturer 4. Airplane manufacturer delivers airplane to bank 5. Bank leases airplane to airline in exchange for lease rental payments; at the end of lease term, ownership of airplane transferred to airline Airline 2. Airline approaches bank 1. Airline places order with to seek financing airplane manufacturer  Sale and Leaseback 1. Company sells plant to bank 2. Bank pays cash for plant Bank 3. Bank leases plant to company Manufacturing Company 4. Company pays periodic lease rental payments 5. At the end of lease period, company repurchases the plant With this arrangement, the manufacturing company obtains liquidity, using its existing assets  Decreasing Sale and Joint Lease Airplane Bank Manufacturer 3. Airline makes periodic payments to 2. Bank bank comprising: simultaneously sells its share of (i) Installment ownership to the 1. Bank and airline payment for purchase airline and leases jointly purchase of bank’s share its share to the airplane airline (ii) Lease rental payments Airline Sale of the bank’s share in ownership of the airplane to the airline is made on deferred payment basis (BBA) At the end of lease period, the airline has complete ownership of the airplane Refer to banks’ websites for examples of vehicle leasing Loading…